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Monday, July 4, 2011

The Most Important Thing: Chapters 5 and 6

Value investor Howard Marks shares his investment philosophy in his book, The Most Important Thing: Uncommon Sense for the Thoughtful Investor. "This is that rarity, a useful book," according to Warren Buffett. Marks' estimated net worth is over $1 billion and his firm, Oaktree Capital, manages $80 billion.

Because investment returns are based on events that will take place in the future, risk in investing is inescapable, according to Marks. Furthermore, an understanding of risk is essential. Simply looking at a manager's returns does not tell you how much risk was employed in generating those returns, but an understanding of the risk employed is essential in ascertaining whether the manager is indeed skilled.

Conventional market theory asserts that high risk results in high returns. While Marks agrees that investors need to be compensated for taking on more risk, there are several problems with how conventional theory views this point.

First, the definition of risk is considered to be price volatility by conventional theorists. Marks rejects this definition. He argues that it is convenient to use volatility as the measure of risk, but that risk of loss of capital is what risk really is.

By this definition, however, risk is not measurable. Instead, risk is subjective, hidden and unquantifiable. As such, it can't be computerized, as the output would only be as good as the inputs and assumptions relied on. Marks argues, therefore, that only sophisticated, experienced, second-level thinkers can properly evaluate risk.

Risk can't even be analyzed in retrospect. Just because an investment worked out (or didn't), doesn't mean the risk warranted (or didn't warrant) the investment in the first place. There is only one history, but there were many possibilities that could have occurred but didn't due to chance.

Marks argues that risk is highest when it's perceived to be low. The low perception of risk leads to high prices, and it is high prices that lead to risk. Many investors associate risk with the quality of the asset, when it actually has to do with the price paid for the asset. At some point, even a low quality asset can have low risk when the price paid is very low.